A Backdoor Roth IRA Strategy

Funneling money into your Roth when your income surpasses the IRS’s limits

A Roth IRA is a great way to build wealth. That’s because not only is growth inside a Roth tax deferred, it can also provide you with tax-free income once you retire.

But while many Americans take advantage of contributing to a Roth IRA, there are still countless folks who’d like to but their incomes are simply too high for them to qualify.

That’s because in order for a couple to make a full contribution to a Roth IRA, their combined modified adjusted gross income (for 2017) must be less than $186,000 (or $118,000 for single tax filers).

Is your income higher than these limits? If so, you probably thought there’s no point in pursuing it.

Not. So. Fast.

Have you heard of the “backdoor Roth IRA” strategy?

With a backdoor Roth IRA, a person makes a non-deductible IRA contribution and subsequently converts that traditional IRA to a Roth IRA.

There are of course a few hurdles to jump over, which I’ll cover, but I think any inconvenience is well worth it.

Looking back a few years, when Roth IRAs were first introduced (in 1997), there were income limits that restricted people from converting an existing IRA to a Roth IRA. However, a few years ago the restrictions on Roth conversions were lifted, thereby enabling taxpayers of all income levels to convert to a Roth.

Here’s what makes a backdoor Roth IRA work: A person can contribute up to $5,500 per year to an IRA ($6,500 if age 50 or older), so long as that individual has at least that much in either wage or self-employment income, and is under the age of 70½.

Next, once those funds are in an IRA, it’s subsequently converted to a Roth IRA and, provided that individual has no other IRA assets, the Roth conversion doesn’t create any tax consequences because the conversion took place with dollars that have already been taxed.

The backdoor Roth IRA strategy at work.

Here’s an example: Jane Smith earns $140,000 and would like to place as much money as possible into her retirement accounts. She’s maxed out her 401(k) at work, and she doesn’t contribute to an IRA each year because she knows she won’t receive a tax-deduction for it (her income is too high).

This year, however, she decided to make a non-deductible IRA contribution of $5,500. She does this transaction through her financial institution on a Monday, and then the following week she turns around and instructs the financial institution to convert that IRA to a Roth. The financial institution completes the conversion so that Jane has a Roth IRA with a balance of $5,500.

At the end of the year, Jane receives a statement that reports her $5,500 IRA conversion, but she owes no taxes on that conversion because her “cost basis” (the amount she contributed to her IRA) is the same as the amount she converted.

This works because she didn’t have any other IRAs. (Speaking of IRAs [and 401(k)s], when was the last time you checked your beneficiaries?)

Can you utilize the backdoor strategy if you already have an IRA?

Yes.

Again, using Jane as our example, let’s suppose she has an existing IRA with $50,000 in it. At first glance, a backdoor Roth IRA strategy wouldn’t work in this situation because she’d have to account for her other IRA monies, which would trigger a tax liability if she converted anything to a Roth.

But she’s not without options.

That’s because even in this scenario, what she could do is transfer her $50,000 IRA to her employer’s 401(k) plan prior to the conversion. This would leave her with zero money in a traditional IRA. Once she no longer has a traditional IRA, she could then fund a non-deductible IRA, convert that to a Roth and avoid income taxes entirely.

If you’d like to contribute to a Roth IRA, but your income is too high, it might be time to utilize the backdoor Roth IRA option. Contact us today for more information on this, and other savings and investment strategies.

The backdoor Roth may be a bit of work, but it can pay off, particularly if you stay vigilant and contribute year after year.

†As of 03/16, Hanson McClain Advisors, an SEC registered investment adviser and Hanson McClain Securities, a registered broker/dealer have approximately $2 billion in total assets under management and administration.

✢Scott Hanson, Investment Advisor 2005, 25 most influential people in the financial services industry. The ranking reflects 25 people who Investment Advisor magazine believes have had or will have the greatest influence on the financial services industry.

✼Pat McClain, InvestmentNews 2014, Invest in Others Community Service Award, presented to an advisor who has made an outstanding impact on a community through managerial contributions to a non-profit organization.

Financial Times, FT 300 Top Registered Investment Advisers, June 2016. The ranking reflects six areas of consideration including the company's years in existence, industry certifications of key employees, AUM, asset growth, SEC compliance record and online accessibility and calculates a numeric score for each company.

The NBRI Circle of Excellence Award is bestowed upon NBRI clients meeting one or both of the following criteria: Total Company score at or above the 75th percentile of the NBRI ClearPath Benchmarking Database and/or improvement of five (5) or more benchmarking percentiles in Total Company score over the previous survey.